Market efficiency

It is appropriate to end this section on price discovery with a brief discussion on the concept of financial market efficiency?7 Market efficiency is concerned with how well the financial market functions in terms of price discovery, i.e. (in the case of the share market) the degree to which share prices reflect available information about the listed companies and change to reflect new information.

There are three standards (some call them measures) of market efficiency and all have been intensely researched in order to determine whether share prices do indeed reflect all information. The reason for the research was (and is) of course to make a return if the markets do not reflect all available information. The three standards are:

• Weak form market efficiency.

• Semi-strong form market efficiency.

• Strong form market efficiency.

Each standard has a different objective in terms of market efficiency:

• Weak form market efficiency - does the market reflect all past market information?

• Semi-strong form market efficiency - does the market reflect all information about listed companies that is available to the public?

• Strong form market efficiency - does the market reflect all possible information about companies, including private information (i.e. insider information)?

It should be apparent that the three forms are concerned with how efficient the share market is. The degree of efficiency is significant because it determines the value the investor places on various types of analysis undertaken to select shares.

The evidence supports weak form market efficiency and holds that current prices reflect all historic information about the market. Thus stale news, price trends, trading volume data, rates of return, etc, are already incorporated in current prices, and are of no use in explaining or forecasting current and future prices. Thus, weak form market efficiency says that investors cannot earn more than the fair (or required) return, by using past information. This of course means that if a market is weak form efficient then technical analysis is of little use. However, it does suggest that superior fundamental research can produce returns that are in excess of the return that is consistent with the risk undertaken.

This theory is consistent with the random walk hypothesis, i.e. that changes in share prices follow a random walk, are independent of past price performance. Note the emphasis on changes; this is emphasized because the levels of prices are not determined randomly. They are efficiently determined by many factors such as earnings, interest rates, dividend (retention) policy, economic environment, etc, and any changes in these variables are rapidly reflected in share prices. However, new information is random because it is unpredictable (if it were predictable it would be incorporated in prices), and therefore prices change in response to new information.

Semi-strong form market efficiency is concerned with achieving abnormal returns upon the release of new public information. Thus, a market is semi-strong form efficient if new public information is imputed into prices immediately.

The evidence suggests that this is the case. The test here is the quickness with which share prices adjust upon the release of new information about specific companies. In the case of share markets that are quote-driven, the market is semi-strong form efficient if the bid/offer quotes of the market makers are adjusted immediately without any transactions being done that someone can profit from. If the market adjusts slowly to the new level, based on many transactions that bring this about, then the market is not semi-strong form efficient.

Thus, no person / institution can achieve superior results to the market when the market is semi-strong form efficient. However, there is one exception to the contention that the market is semi-strong form efficient: when someone has insider information. The possessor of this information is able to achieve return results that are superior in a market that is semi-strong form efficient.

In the case of strong form market efficiency it is said that a market is strong form efficient if market prices fully reflect publicly announced and private information. This standard is difficult to test, because inside information is not available to the public (by definition). However, logic dictates that abnormal returns can be made on information that is not publicly available. It will be evident then that if this insider information is later made available to the public, and prices adjust immediately, it would not reflect strong form efficiency, but semi-strong form efficiency.

There have been cases where "insider trading" has taken place, and some perpetrators have been caught out because the relevant share price changed for "no reason at all". This would be the comment of observers without the information. The reason of course becomes apparent after the release of the information. Investigations then take place as to why the share price changed "for no reason at all", and the perpetrator is usually identified.

This of course means that the holder of private information is able to outperform the market, which points to the market not being strong form efficient. This is manifested in most countries having laws prohibiting this behaviour (usually called the Insider Trading Act).

A final note: the efficient market hypothesis (EMH) declares that financial markets are informationally efficient and this means that investors cannot consistently achieve returns in excess of average market returns, because all investors have and act on the same information. The EMH is largely ignored in modern investment theory, and its remaining practical usefulness lies therein that the participants in the market who act on new information and expected future information, including the speculators, all contribute to efficient price discovery (EPD) and market liquidity (ML, which contributes to EPD). ML is important in that investors can buy or sell shares with ease, meaning with no or little effect on market prices in the short term.